No Deal

Why you shouldn’t believe the theory behind Groupon’s business model.

Accounting is boring. High-tech innovation and fast-growing startups are fun. But sometimes boring things are important. And Groupon, the fast-growing market leader in the daily deal business, can’t seem to get its accounting right. On Friday, the company issued an earnings restatement saying they’d actually lost $64.9 million in the fourth quarter of 2011 rather than the $42.7 million they’d originally reported. That’s an embarrassing mistake, to be sure, but what makes things even worse is that the company’s accountants, Ernst & Young, said it wasn’t just a one-off error—rather, it reflected a “material weakness” in the company’s internal financial controls. But the bigger problem isn’t the losses or the restatement or even the material weakness in the controls. What investors should be alarmed about is a material weakness in Groupon’s underlying business model.

The specific error in Q4 has to do with the somewhat odd timing of the inflows and outflows of Groupon’s revenue. At any given time, the company is selling a variety of “deals”—discount prices on goods and services. Since the deal itself is the product Groupon sells, you hand the money over to them right away. Money is then paid out to the service provider on an agreed-upon timetable, and at some later point a customer actually redeems his coupon. As Groupon has started moving into deals for higher-value services, it began allowing customers to back out and get refunds under certain circumstances. In its initial report, Groupon failed to account for a surge in refunds and thus over-reported its revenue. Ernst & Young’s material weakness comment referred to a failure to account for the possibility of refunds. Neither the specific error nor the existence of a bad accounting procedure is necessarily all that damning. Groupon has been an extraordinarily fast-growing company in terms of revenue, and it’s understandable that the company’s core executive team has been more focused on growing the company than mucking around with accounting procedures.

If Groupon is a wildly successful business 10 years from now, we can expect this early brush with accounting woes to be an endlessly repeated anecdote about the culture clash between brash go-getting entrepreneurs and boring green eyeshade suits. CEO Andrew Mason’s early clash with the Securities and Exchange Commission, in which a memo he authored touting the company’s prospects leaked to the public during the “quiet period” that legally must precede an IPO, also fits into that bucket. The rule Mason broke is fussy and somewhat antiquated, and the idea that the investing public needs to be protected from CEOs bragging about their own businesses is odd. A mature executive should know better than to break the law, but nobody is shocked to learn that innovators sometimes bristle at these kinds of rules.

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Groupon’s problem today is that the new accounting mix-up is bound to remind people of the company’s very first accountant-related controversy, their departure from Generally Accepted Accounting Principles in their initial IPO filing. On paper, this was cleared up swiftly. The SEC didn’t like Groupon’s heavy reliance on a non-GAAP method, segments of the business press howled in outrage, and the company filed a new S-1 that de-emphasized the newfangled Adjusted Consolidated Segment Operating Income. Groupon’s problem is that this wasn’t a question of fussy rules but represented a real difference in theory about how to think about the business. And Groupon is probably wrong.

The reason we have GAAP is that assessing a business’s health isn’t as simple as watching money flow in and out. Sometimes money goes out the door as an operating expense, like when Slatepays our electricity bills. But sometimes you’re investing in tangible assets, like when we buy desks or computers. Tangible assets are sometimes very expensive, but they also last a long time. And they might last different amounts of time. An airplane or a desk retains a lot of value, whereas a computer becomes obsolete relatively quickly. GAAP exists so that different firms with different investments in different kinds of equipment can produce comparable financial statements.

Why did Groupon use a different metric? Because it wanted to show that the company has a very healthy operating margin if you exclude the marketing costs incurred in its effort to obtain new customers. On one level, their preference for the ACSOI metric told us nothing. It’s nothing new for tech startups to prioritize growth over profitability in their early stages. But there was an important underlying theory here: that the deal industry has strong network efforts and high barriers to entry. Once everyone is on Facebook, the fact that everyone else is on Facebook becomes a good reason to be on Facebook. And since everyone’s on Facebook, everyone wants to develop aps for Facebook, which becomes another good reason to be on Facebook. In a business like that, doing whatever it takes to obtain a dominant position is the smart strategy. So Groupon might need to incur gigantic marketing expenses to get everyone to sign up, but then should be able to ease up and earn healthy profits by cheaply re-pinging existing customers.

The problem is that it’s never been clear why we should believe this. As opposed to the massive costs of starting up a new social network, there are no meaningful barriers to entry in the deals field. Groupon competes with LivingSocial, and the growth of those two companies has spawned an endless series of imitators. What Groupon acquires with its marketing dollars is little more than a customer’s email address. Any company could go out and buy a list of similar email addresses (which could be properly accounted for as an investment) for much less than Groupon spends on marketing.

The risk for Groupon is that the market leader in the daily deal game will find itself in the position of a McDonald’s or a Coca-Cola. You’d rather be No. 1 in burgers or soda than No. 2, but these leading brands are hardly free from the yoke of advertising costs. Instead, the advantage size gives a company like McDonald’s is ample revenue that allows them to mount ambitious marketing efforts to keep the brand shiny and visible. These costs aren’t one-time investments—they’re constant expenses in a never-ending struggle. There’s nothing wrong with being a business with high marketing costs, but if you’re in a marketing-intensive industry then you need revenues high enough to cover your costs. Groupon doesn’t have that, and lurking beneath its various accounting woes is the dubious underlying theory that they’ll never need them.